What if this is just a bear market rally and we tumble another 30, 40, 50%?
What if the economy has bottomed, but things don’t really get better for years?
What if the worst is behind us and we start a new generation of growth and prosperity?
If you are 100% confident that you know which of these scenarios is correct, then you are just kidding yourself. The economy and the stock market are simply too complex for anyone to know with such exact certainty. Meaning that not you, nor me, nor Cramer, nor Buffett, nor anybody has this one down pat.
The best we can do is roll through all the “What if?” scenarios. From that we will discover the tell tale signs of which case it will be. Then align our portfolios to maximize profits in that environment. And yes, we can make profits in each and every one of these environments. So, let’s get started.
What If This Is Just Just a Bear Market Rally?
This is the worst case scenario for the economy and society as a whole. But with trillions of dollars in bad loans, derivatives and sovereign debt issues still looming out there, we have to assume it’s a real possibility.
Here are the signs to look for:
General Economic Weakness: There are a number of key economic indicators to look out for. Since consumer activity accounts for 70% of the economy, then deteriorating retail sales is a very bad sign. Also watch unemployment rate and sentiment indicators. If they erode instead of the recent modest improvements, then it spells trouble.
More Banking Trouble: This could come in many forms. But if the government’s stress tests were not adequate or there are more bad loan boogeyman looming about, then we are right back where we started with this mess.
Deflation: Meaning the cost for goods start getting cheaper. Its sounds nice on the surface, but it’s a deadly economic disease that took hold of the US during the Great Depression. It also spelled disaster in Japan during the 1990’s, now referred to as the “Lost Decade”.
Clearly any of these items coming to the surface would result in renewed panic and a tumbling market. Here is how to profit in this environment:
- Sell all small cap, aggressive or speculative stocks: These stocks go down first…and they go down the most.
- IF you are going to own any stocks, then they need to be the bluest of blue chips with large dividends in defensive industries like food, healthcare, utilities etc.
- Short the market: I believe the best way to do this is with inverse ETFs that allow you to profit as the market goes down. There are also “Ultra” inverse ETFs that can give you extra exposure to amplify your potential profits (and potential losses if you guess wrong). Some of my favorites are QID, SDS and TZA.
- Nothing wrong with having a lot of cash on hand. Or gold as a safe haven.
The odds of you seeing these signs clearly and perfectly timing your way into the proper trades is very low. Just realize that it’s better to be a shade late to the party, then not show up all. That should put you in the right frame of mind.
What if Things Don’t Really Get Better for Years?
Here we have the scenario where the economy doesn’t get any worse…it just doesn’t seem to get much better either. The signs to notice this predicament are easy. Essentially all the indicators of the economy (GDP, retail sales, manufacturing etc) just get stuck at the recent modest levels and don’t improve any further.
The market, however, can follow two very different paths during these times. And each requires radically different tactics to be successful.
Path 1- Range Bound Market: This would entail the market, just like the economy, going basically nowhere for an extended period of time. We often call this a range bound market as it just trades within a narrow 10-15% band.
These markets are actually easy to profit in. That’s because most companies will have modest earnings growth. But the few that are growing at a rapid pace will attract investor attention and rise in price. You will find these stocks by concentrating on the best stocks in the best industries. The best industries are those with the healthiest earnings outlooks (easily found with the Zacks Industry Rank). And then you pick the stocks with the best earnings outlooks within those industries (using the Zacks Rank for stocks). Also in this environment you shouldn’t try to be too aggressive. Concentrate on mid-cap and large-cap stocks which provide a bit more safety. Current stocks that come to mind are Apple (AAPL), Texas Instruments (TXN) and Autoliv (ALV).
Path 2- Volatile Market: Here you have a market that keeps misreading economic signals. You will see big 20-30% run ups on renewed hopes of economic improvement. This is followed by an equal sized downturn as people discover that the growth prospects were just a mirage. At the end of the day the market goes nowhere like Path 1, it just keeps flying above and below the breakeven level.
This environment is trickier, but can be tamed. You just need to apply market timing with a dash of common sense. If the market tumbles and it seems overdone, then buy up good stocks like noted in Path 1 above. When the rally gets overextended and signs of economic growth are missing, then take your profits. Rinse and repeat as many times as needed.
What If This Is the Start of a New Generation of Economic Prosperity?
This is the one we all hope for, but fear is too good to be true after all the recent devastation. Yet it is possible that the coordination of government actions around the globe have thwarted a second Great Depression and that we can start to enjoy a prolonged era of economic growth and well being.
Here we have the inverse of the first scenario. Meaning that we hear less and less about banking troubles. The unemployment rate will start heading lower. Inflation stays in a normal 2-3% range. Consumer and manufacturing indicators show even more improvement and GDP numbers continually come in at +3% or better.
This is the easiest environment in which to profit in the stock market as most everything will rise. However, small caps and high beta stocks which consistently blow away their earnings estimates will significantly outperform. Again, the Zacks Rank is an excellent guide to find these likely winners.
What Do I Think Will Happen?
Which scenario do I believe in right now? And what’s in my portfolio to profit in this environment? I’ll give you a hint. Right now I think the most likely outcome is the second scenario, which some might call a “Muddle Through Economy”. However, I do sleep with one eye open that all those bad loans and government printing press actions come back to haunt us down the road. So I do have contingency plans in place to switch to scenario 1 if necessary.
Disclosure: If I mentioned the stock favorably, I most likely own it.
